What Happens when China sneezes…?
Global equity markets have seen some of the most precipitous declines ever over the past three weeks. The US is, for all intents and purposes, in bear market territory, down 19% from the all-time high on 19th February 2020. Other developed and emerging markets have also seen sizeable falls from recent highs. Japan is down roughly 20%, Korea down 14%, Germany 23%, and the U.K. approximately 22%.
The growing threat posed by the spread of coronavirus, combined with a side-order of an all-out oil price war between Saudi Arabia and Russia, has finally caused market sentiment to change dramatically for the worse. Catalysts are as hard to predict as they are inevitable, and the catalyst we all knew would eventually arrive is here, bringing an end to the longest ever U.S. bull market. Investors are now being reminded that markets can fall a lot faster than they go up.
So, what is the right course of action now?
So, what is the right course of action now? Is this a threat or an opportunity? Is it time to reduce risk by selling assets and reducing equity exposure, or to double down by adding more?
Well, firstly, the coronavirus is a big deal. There are likely a lot more infections than are reported and, equally likely, more deaths than have been reported. The coronavirus, and the actions being taken by governments and individuals to reduce the rate of its spread, is causing devastation amongst supply chains and unclear damage to consumer confidence and demand. Companies are cancelling events and travel left and right and that is unlikely to change soon. There will be bankruptcies as a result of the economic turmoil currently being caused by the spread of the coronavirus. The dramatic decline in the price of crude oil (down 24% on Monday and now lower than it was 20 years ago) is adding to the drama by causing consternation amongst increasingly fragile credit markets.
Market valuations are driven more, in the short term, by capital flows, which are driven by sentiment and how much risk people want to take. More than ten-years of a monetary-policy fuelled bull market has had investors increasingly complacent about the price they paid for assets. The investment motive had increasingly become, FOMO, or fear of missing out. Rather than basing investment decisions on intrinsic value, investors were simply asking, what will someone else pay me for this asset at a later date? Now, with equity prices falling, investors are being asked to answer the more difficult question, what is this asset/company really worth?
People currently want to take money off the table, so sentiment is driving the market rather than true economic disruption, even given the potential economic costs discussed above. Markets are meant to discount decades of future cash flows into current valuations but, in moments of extreme greed or fear, it is sentiment and desire to adjust risk levels that drives markets.
Never is this more important than when it is hardest.
But, all is not lost. While it is impossible to determine how the coronavirus will play out over the next 3-5 months, it is much easier to make an educated guess as to what the world will look like in 3 to 5 years. And, it will likely look much like it did three weeks ago. It always pays to keep an eye on the longer term when making investment decisions. Never is this more important than when it is hardest.
The steady hand on the tiller wins the race and those that keep their eye on the horizon can take advantage of the volatility that the public market is currently experiencing. “Doing nothing” can be an active decision and, for many people, that is most probably a sensible course of action. Don’t change well thought out and executed plans due to short term fear and turmoil. An even better decision can be to use the opportunity to rebalance into cheaper assets and to upgrade the quality of assets held. It can be an opportunity to reassess, what has gotten cheaper, and what has gotten relatively more expensive.
It is a fact that assets are cheaper today than they were a month ago. But are those prices attractive in an absolute sense?
It is a fact that assets are cheaper today than they were a month ago. But are those prices attractive in an absolute sense? The U.S. market has been at increasingly elevated levels for some time. We noted, in our recent quarterly letter to our investors, that the large increase in U.S. equity markets in 2019 was largely driven by increases in valuation multiples, not earnings growth. The abrupt market decline of the past three weeks, while striking, only takes valuations back to where they were in January 2019. Many companies that we track in the U.S. have only come back to their long-term average valuation levels rather than presenting overly compelling investment opportunities.
In other markets, such as China, the valuation levels were more attractive three weeks ago and, consequently, despite China being the epicentre of the coronavirus, the Shanghai index only fell 12% in late January, but has since clawed back much of that loss to be only 5% down from the recent high. While the U.S. has, arguably, gone from somewhat expensive to fairly-priced, in other markets, prices have gone from fair to attractive. We are trawling through our watchlist which contains many high-quality companies that have been too expensive compared to our view of intrinsic value but are rapidly coming back into striking distance
It is very hard to time market tops and bottoms, so, rather than trying to do so, the key question should be, is this a price for this asset at which I am getting an attractive return for the risk that I am taking on? While this is not a time to go all-in, all at once, there are, increasingly, some real bargains on offer if one looks out 3-5 years rather than focusing on what might happen to the price over the next 3-6 months. Buying in times of turmoil is never straightforward, but a long-term view can help to keep the hand steady on the tiller.
Avenir Capital is an Australian based investment manager, specialising in value-oriented global equity investments. Get our latest insights by hitting the follow button below.
Adrian Warner is the Managing Director and Chief Investment Officer of Avenir Capital and is responsible for the portfolio management of the Avenir Global Fund. Prior to founding Avenir Capital, Adrian worked in private equity investment in...